Pension investing using ETFs: Part 3

In the now-iconic scene set in Katz’s Delicatessen in New York City, a woman of some years mischievously asks her waiter to bring her the rye and pastrami sandwich she assumes was responsible for Meg Ryan’s character Sally’s head-turning display of euphoria. Portfolio envy is a lesser-known form of a similar syndrome.

In pension terms, Sally has a defined-benefit (DB) portfolio. Harry has a defined-contribution (DC) plan, but overestimates his ability to distinguish real money management from fake management.

DB plans are managed by professionals and are meant to provide members with reliable income in retirement. DC plans, including RSPs, are managed by reluctant plan members from a bewildering array of mutual funds not designed for DC pensions. No wonder people want what Sally is having. Professionals have not done that well with DB plans, either. Plans were only 73% funded at the end of 2010 in Canada, according to Mercer.

One-hundred-percent funding means they can meet their obligations. As well, Mercer predicts pension scheme deficits overall are expected to more than double, from about $20 billion to just under $50 billion.

Investment professionals are not solely to blame. Employees and unions push for better benefits, asset managers lobby for more equities — which bring them higher fees — and employers take more risk in the hope that higher returns will lead to contribution holidays. In the financial crisis, inadequate risk controls penalized even the best DB plans.

Building the fool-proof portfolio

Exchange-traded funds (ETFs) give individuals and their advisors the tools to build sophisticated portfolios. Maintaining appropriate risk and reducing volatility as a target date approaches are the flavourful rye bread and richly smoked pastrami of retirement solutions.

Maintaining consistent risk can save investors a bundle. Chart B shows the daily VIX — the implied volatility of S&P 500 options — is a readily available proxy for risk. Levels higher than 20 were good times to become cautious — 1997 to 1998 and 2007. Levels above 30 were good times to hide (1999 and 2008). Conversely, periods of stable or declining VIX — levels under 20 — would have been good times to own stocks.

Ioulia Tretiakova, Director of Quantitative Strategies at PUR offers this example using a hypothetical portfolio consisting of iShares’ S&P TSX Capped Composite Index Fund (XIC) and iShares DEX Universe Bond Index (XBB). If VIX is under 20, the portfolio shifts to 100% XIC. If VIX is between 20 and 30, the asset mix is 50% XIC and 50% XBB. If VIX is over 30, the portfolio shifts to 100% XBB.

The strategy improved the return not only of the all-equity portfolio, as expected, but also of a diversified 60/40 balanced portfolio while maintaining similar risk.

Most investors would find a portfolio that moved from 100% stocks to 100% bonds too active. An alternative is to apply the same rules to the equity portion of a portfolio. Table A shows corresponding equity weights for balanced portfolios at 80/20, 60/40, and 50/50. We believe wider asset allocation shifts than those many investors have become accustomed to are the future of investing in volatile markets. This suggests a more active role for knowledgeable advisors and registered reps.

Mustard: a dynamic glide path

Today’s target date mutual funds are fundamentally flawed. All have static glide paths that reduce equity exposure as the target date approaches (see Chart A). It sounds like the portfolio’s risk is reduced over time, but risk is not static. Equity risk can change dramatically over a working lifetime so that 60% equity means something very different at the peak of the technology boom than it does at the bottom of the financial crisis in 2009.

Indeed, observing the relative performance of three portfolios — a hypothetical Constant Risk Canadian Equity, S&P/TSX Composite, Morningstar Canadian Equity Balanced Index — from February 2001 (when XIC data became available) to April 2011 shows large gaps after 2009. The remedy is to manage a portfolio to have declining risk over time.

Examples shown in this article are based on daily VIX, but a monthly approach would also be beneficial. PUR will post updated risk data monthly on its website (www.purinvesting.com) for those interested in following along.

The pickle

A kosher dill is essential to finishing off the dish. In a similar way, diversification will help to dampen risk further. Our simple stock-and-bond model is a guideline only.

This approach is theoretically better than anything available today for DC plan investors. Maybe both Harry and Sally will want what you are having!